The proposal will have little effect on the economy but could cause more harm than good
Tonight, President Obama will speak to the nation about ways in which he believes Washington can inject some adrenaline into the languishing economic recovery. It isn't hard to figure out why: job growth has been trending down and may have ceased altogether in August. With unemployment still near double digits, that's a big problem.
Some reports indicate that he'll announce one stimulus measure that purports to cost taxpayers nothing. The administration may push Fannie and Freddie to allow more homeowners to refinance at current very low mortgage interest rates. The measure might sound good in theory but will ultimately amount to another failed attempt at healing the housing market and broader economy.
Inside Mortgage Finance reports that the president could announce what it calls a re-worked "Home Affordable Refinance Program" ("HARP 2.0"). The idea is simple enough: push the agencies to allow more borrowers to refinance at very low interest rates, around 4%. For borrowers with mortgage rates at or above 6%, this savings becomes real money that can be spent to stimulate the economy.
How much money are we talking about homeowners saving? It depends on their previous interest rate and mortgage size. For a family that originally had a $250,000 mortgage at 6%, moving to a 4% interest rate would cut their monthly payment by at least $300. If their mortgage payment was initially 35% of their income, then this is like giving their income a 7% boost.
The administration might like this plan for two reasons. First, it wouldn't take any legislation if the Federal Housing Finance Authority coerces Fannie Mae and Freddie Mac to go along. Second, it wouldn't directly cost taxpayers anything or increase the size of the deficit.
There Is a Cost
But generally, whenever someone is gaining money, someone else is losing that money. This proposal is no exception to that rule. The losers here would be mortgage bond investors and taxpayers.
Loss to Investors
When you purchase a mortgage-backed security, you've got to worry about two sorts of risk: default risk and prepayment risk. That first sort is straightforward enough: if homeowners stop paying their mortgage, then you may incur a loss related to that default.
The second, however, is a little more subtle. The interest and principal payments made by borrowers eventually make their way to investors through bond interest and principal payments. But if borrowers pay back their loan quicker than anticipated, then the mortgage bond is paid off sooner. As a result, the investor's bond doesn't provide as much interest as it was expected to pay over a given time period.
In the case of MBS issued by Fannie and Freddie, investors only have to worry about prepayment risk: the government covers any losses due to defaults. But they can't escape prepayment risk. As more borrowers refinance, prepayment risk grows. As a result, if the government encourages more refinancing, then these agency MBS would lose value.
Loss to Taxpayers
Of course, taxpayers would face a similar loss: any mortgages still held in Fannie's or Freddie's portfolios that are refinanced would be paid off early. That loss might not show up as a direct cost, since it consists of interest that will never be paid. But this additional interest would have offset some of Fannie and Freddie's losses over time, for which taxpayers are on the hook.
Taxpayers could lose in another way. Presumably, most borrowers that wanted to refinance and could qualify have done so. Those who would like to refinance but haven't can't qualify. That's because either they aren't a prime borrower and/or their mortgage is underwater.
So we can conclude that this refinancing effort would have to be focused on relatively risky borrowers. If they're paying a lower interest rate and do eventually default, then the loss (taking interest paid into account) to Fannie, Freddie, and consequently taxpayers will be greater than if they hadn't refinanced.
Some might argue that a lower interest payment could prevent borrowers from defaulting. But that is more likely the exception rather than the rule. While lower interest payments will help some homeowners to save a little money, they won't usually be enough to prevent default if a homeowner is struggling due to unemployment or some other economic-driven problem.
Next, this stimulus wouldn't nearly be universal. It would be available to only a subset of borrowers who happen to have a mortgage backed by Fannie and Freddie. So its recipients would be fairly arbitrary.
Worse than that, the stimulus will necessarily benefit relatively wealthy Americans, since it targets homeowners. Sorry renters, you lose again. And remember: the bigger your mortgage, the more you benefit -- up to the agency conforming limit, that is. The administration could put a cap on mortgage size of those eligible, but what would be the point of that? If this is meant to stimulate the economy, then why limit its participation?
Will It Even Help?
Of course, all of this assumes that the FHFA will go for it. According to Inside Mortgage Finance, the agency probably won't. It reports that the FHFA will oppose any proposal that does not require borrowers to re-qualify for a refinancing. So the only borrowers that would get this refinancing would be those who the FHFA judges to have strong credit worthiness and little to no negative equity. But can't that population refinance already?
As a result, we shouldn't expect this option to prevent many foreclosures. Underwater and struggling homeowners will likely be excluded. Remember, the Obama administration does not have much power over the FHFA. We have seen this demonstrated by Fannie and Freddie's policy not to perform mortgage principal modifications, much to the Treasury's frustration.
The Harm It Will Cause
As so many other government attempts to wade into a market, this policy would create really strange distortions. The more borrowers obtain these ultra-low rate mortgages, the fewer will be willing or able to move in the years to come once interest rates return to normal levels. For example, if a family wants to move to a different city in a few years, it may not be able to afford a similarly priced home if the mortgage rate is much higher.
The housing market will boil down to two sets of homeowners: those deeply underwater and those with ultra-low interest rates. Neither group will be willing or able to move unless they absolutely must or have some enormous incentive to do so. If homeowners are stuck in their home because they don't want to lose their ultra-low mortgage interest rate, then labor mobility will decline. When unemployment is high, this problem is particularly significant.
Time will tell if the president really plans on proposing this mortgage refinancing strategy. This idea has been floating around in various forms for more than a year, so we'll have to wait for his address to see if this report is true. Let's hope it isn't, as the effort would do little good and could actually make the economy worse off.
Image Credit: Reuters/Shannon Stapleton